Revised Fall 2012 CHAPTER 12 STATEMENT OF CASH FLOWS Key Terms and Concepts to Know The Statement of Cash Flows reports the sources of cash inflows and cash outflow during an accounting period. The inflows and outflows are divided into three sections or categories based on the underlying cause or nature of the cash flows: Operating Activities Investing Activities Financing Activities Because the statement explains the changes in the cash balance during the period, the beginning and ending balances in Cash are not included in these three sections. Cash forms a fourth section at the bottom of the statement in which the beginning cash balance is added to the total of the three sections to determine the ending balance for cash. At times, companies enter into investing and financing transactions that do not involve cash, such as issuing common stock to purchase land. These transactions are not reported on the statement of cash flows because they do not provide or use cash. Instead, they are reported in a separate section or note which is presented after the ending cash balance. Page 1 of 26 Revised Fall 2012 Key Topics to Know The statement of cash flows explains the changes in the balance sheet during an accounting period from the perspective of how these changes affect cash. As noted above, the cash inflows and outflows are divided into three sections plus a cash section based on the balance sheet accounts underlying the cause or nature of the cash flows. Investing and financing activities that do not involve cash are presented in a separate schedule. Cash Flow Statement Section Balance Sheet Accounts Operating Activities Net Income = revenue – expenses Current assets excluding cash Current liabilities excluding dividends payable and short-term notes payable Investing Activities Non-current assets Financing Activities Long-term liabilities Short-term notes payable Capital stock and treasury stock Dividends declared and dividends payable Cash Cash Non-cash Investing and Changes in long-term liabilities, short- Financing Activities term notes payable, capital stock and treasury stock that do not involve cash Practice Problem #1 Identify which section of the statement of cash flows each of the following events would appear in (operating, investing and financing or in a separate schedule): a) Purchased a Patent b) Sold Treasury stock c) Net Income d) Sold long-term investments e) Purchased a building f) Issued bonds. g) Paid dividends h) Recorded depreciation expense for the year i) Issued common stock to retire a mortgage j) Purchased treasury stock Page 2 of 26 Revised Fall 2012 Operating Activities Operating Activities include the events and transactions that determine day-today operating activities. These events and transactions include net income and the changes in the current asset and current liability accounts related to net income. Those transactions and events that do not provide or use cash are excluded from determining cash flows from operating activities. For example, sales on account are used to determine net income, but to the extent that these sales remain uncollected at the end of the period, the increase in accounts receivable is not a cash flow and must be deducted when converting net income into cash flow from operating activities. Examples of non-cash transactions include depreciation, depletion and amortization expense and gains and losses from the sale of plant assets and the retirement of bonds. There are two methods of preparing the operating activities section: Indirect Method and Direct Method. Both methods calculate the same total of cash flows from operating activities, although the methodologies are considerably different. Indirect Method The indirect method starts with net income and adjusts it for non-cash transactions and other cash used by or provided by normal daily activities. Net Income Add: Noncash expenses (i.e., depreciation and amortization) Losses on sales or retirements Decreases in Current Assets Increases in Current Liabilities related to operations* Deduct: Increases in Current Assets Decreases in Current Liabilities related to operations* Gains on sales or retirements =Net Cash Flows from Operating Activities *Note that changes in non-operating current liabilities are included elsewhere on the statement. For example, changes in dividends payable are combined the dividends declared to calculate dividends paid in the financing section. Page 3 of 26 Revised Fall 2012 Example #1 Given the following information and using the indirect method prepare the Cash Flows from Operating Activities section of the statement of cash flows. Beginning of End of Year Year Change Cash $ 23,500 $ 37,400 (13,900) Accounts receivable (net) 84,500 80,350 4,150 Inventories 100,200 94,300 5,900 Prepaid expenses 4,970 5,300 (330) Accounts payable (creditors) 71,400 68,900 2,500 Salaries Payable 5,320 6,450 (1,130) Net Income reported on the income statement for the current year was $134,800. Depreciation expense recorded on buildings and equipment was $27,400 for the year. Solution #1 Net Income $134,800 Add: Decrease in prepaid expenses $ 330 Increase in Accounts Payable 2,500 Depreciation Expense 27,400 30,230 165,030 Deduct: Increase in Accounts Receivable $ 4,150 Increase in Inventories 5,900 Decrease in Salaries Payable 1,130 11,180 Net Cash Flows from Operating Activities $153,850 Page 4 of 26 Revised Fall 2012 Practice Problem #2 Given the following information and using the indirect method prepare the Cash Flows from Operating Activities section of the statement of cash flows. Beginning of End of Year Year Cash $345,000 $386,000 Accounts Receivable 554,300 567,800 Merchandise Inventory 693,000 672,400 Prepaid Expenses 27,000 24,000 Accounts Payable (creditors) 510,000 527,400 Wages Payable 39,500 36,000 The net income reported on the income statement for the current year was $465,000, which included a gain on sale of investments of $3,000. Depreciation expense recorded on store equipment for the year amounted to $99,800. Direct Method The direct method starts with the entire accrual-basis income statement (not just net income) and converts it line-by-line to the cash basis. The resulting cash inflows and outflows are the cash flows used by or provided by normal daily activities. For example, accrual-basis sales are converted to cash collected from customers by adding the decrease or deducting the increase in trade accounts receivable. The direct method is preferred by the FASB as it provides more useful information the users of the financial statements. The FASB requires that, if the direct method is used, that a reconciliation of net income to net cash provided or used by operating activities be provided in the footnotes or as part of the statement. This reconciliation frequently looks quite similar to the cash flow from operating activities section prepared using the indirect method. Page 5 of 26 Revised Fall 2012 The operating activities section prepared using the direct method would appear as follows: Cash received from customers: o Sales (+decrease in A/R OR -increase in A/R) Less: payments to creditors and for expenses o Cost of Merchandise Sold +increase in inventories OR -decrease in inventories +decrease in A/P OR -increase in A/P o Operating Expenses +decrease in accrued expenses OR -increase in accrued expenses o Interest Expense +decrease in interest payable OR -increase in interest payable o Income Tax Expense +decrease in income tax payable OR -increase in income tax payable =Net Cash Flows from Operating Activities Investing Activities Investing Activities include events and transactions that affect long-term assets. For example, the journal entry to record the sale of land with a cost of $100,000 for $120,000 would be: Cash 120,000 Land 100,000 Gain on sale 20,000 The effect of this transaction is to reduce long-term assets by $100,000. On the statement of cash flows, the cash proceeds are reported as an inflow in the investing activities section and the gain is deducted from net income in the operating activities section as noted above. If equipment is purchased for $75,000, the journal entry would be: Equipment 75,000 Cash 75,000 The $75,000 would be reported as a use of cash in the investing section. Page 6 of 26 Revised Fall 2012 The Investing Activities section would appear as follows: Cash inflows from: Sale of Long-term Assets o Property, Plant or Equipment o Intangible assets o Investments Less: Cash outflows from: Purchase of Long-term Assets o Property, Plant or Equipment o Intangible assets o Investments =Net Cash Flows from Investing Activities Example #2 Given the following selected information, determine the net cash flows from investing activities and the net cash flows from financing activities: a) Net income was $189,500 for the period. b) Purchased 10,000 shares of common stock at $15 per share for the treasury. c) Sold equipment with a carrying value of $32,500 at a gain of $6,000. d) Purchased land and a building worth $450,000 by signing a ten-year note payable. e) Issued $1,000,000 in bonds at par. f) The beginning and ending retained earnings account balances were $418,000 and $534,000, respectively. There were no prior period adjustments during the period. g) Wrote a check for $648,000 for the purchase of machinery. h) Sold long-term investments in marketable securities with a $50,000 carrying value, at a loss of $17,500. i) Cash dividends were declared and paid during the period. Solution #2 Investing Activities Cash received from sale of equipment $32,000 – 6,000 = $38,500 Cash received from sale of investments $50,000 – 17,500 = 32,500 Cash paid for machinery (648,000) Net cash flows from investing activities ($577,000) Page 7 of 26 Revised Fall 2012 Financing Activities Financing Activities include events and transactions that affect long-term liabilities and equity other than net income.